This era of low-cost oil is different

Having seen numerous fluctuations in the energy markets over the years, many analysts and policy makers have a natural tendency to “look through” the latest drop in oil prices — that is, to treat the impact as transient rather than as signaling long-term changes.

I suspect that view would be a mistake this time around. The world is experiencing much more than a temporary dip in oil prices. Because of a change in the supply model, this is a fundamental shift that will likely have long-lasting effects.

Through the years, markets have been conditioned to expect OPEC members to cut their production in response to a sharp drop in prices. Saudi Arabia played the role of the “swing producer.” As the biggest producer, it was willing and able to absorb a disproportionately large part of the output cut in order to stabilize prices and provide the basis for a rebound.

It did so directly by adhering to its lowered individual output ceiling, and indirectly by turning a blind eye when other OPEC members cheated by exceeding their ceilings to generate higher earnings. In the few periods when Saudi Arabia didn’t initially play this role, such as in the late 1990s, oil prices collapsed to levels that threatened the commercial viability of even the lower-cost OPEC producers.

Yet in serving as the swing producer through the years, Saudi Arabia learned an important lesson: It isn’t easy to regain market share. This difficulty is greatly amplified now that significant non-traditional energy supplies, including shale, are hitting the market.

That simple calculation is behind Saudi Arabia’s insistence on not reducing production this time. Without such action by the No. 1 producer, and with no one else either able or willing to be the swing producer, OPEC is no longer in a position to lower its production even though oil prices have collapsed by about 50 percent since June.

This change in the production model means it is up to natural market forces to restore pricing power to the oil markets. Low prices will lead to the gradual shutdown of what are now unprofitable oil fields and alternative energy supplies, and they will discourage investment in new capacity. At the same time, they will encourage higher demand for oil.

This will all happen, but it will take a while. In the meantime, as oil prices settle at significantly lower levels, economic behavior will change beyond the “one-off” impact.

As costs fall for manufacturing and a wide range of other activities affected by energy costs, and as consumers spend less on gas and more on other things, many oil-importing nations will see a rise in gross domestic product. And this higher economic activity is likely to boost investment in new plants, equipment and labor, financed by corporate cash sitting on the sidelines.

The likelihood of longer-lasting changes is intensified when we include the geopolitical ripple effects. In addition to creating huge domestic problems for some producers such as Russia and Venezuela, the lower prices reduce these nations’ real and perceived influence on other countries. Some believe Cuba, for example, agreed to the recent deal with the U.S. because its leaders worried they would be getting less support from Russia and Venezuela. And for countries such as Iraq and Nigeria, low oil prices can fuel more unrest and fragmentation, and increase the domestic and regional disruptive impact of extremist groups.

Few expected oil prices to fall so far, especially in such a short time. The surprises won’t stop here. A prolonged period of low oil prices is also likely to result in durable economic, political and geopolitical changes that, not so long ago, would have been considered remote, if not unthinkable.

2 comments on “This era of low-cost oil is different”

There is one other factor which gets no recognition. Unlike other times in history, alternative energy has achieved enough cost parity that it is PERMANENTLY removing energy users from the demand curve equation….The US uses LESS oil than it did 5 yrs ago and the economy is certainly more vibrant than it was in 2009. In other words, the assumption that oil prices will reflexively rise as they have in the past as economies improve, is flawed at its core…

This is an important point. The ‘smart money’ knows that oil is running out. Looking at the 25+-year horizon, it seems like a safe bet that solar will be cheaper at current solar prices than oil will over the *average* of the whole 25-year period. So the smart money is investing heavily in renewables, which is a permanent demand reduction for oil